A defensive trade that's easy to buy into

Market lethargy remains well-entrenched across a number as asset classes. That US equity indices closed within 15 bps of flat and EUR/USD had a peak-to-trough range of 45 pips yesterday is a pretty good indication that summer markets have arrived; perhaps it's time to crack on with that reading list!

However, as noted yesterday, Macro Man finds the current benign and, dare he say, complacent, environment unsettling. "Investors" have apparently decided to throw risk at EM assets of virtually every stripe; after all, in a period of low inflation, and with bond yields seemingly having put in a top last week, what else could go wrong?

The answer is plenty.

Macro Man is beginning to wonder if 2007 isn't shaping up as some sort of Bizarro version of 2006. Consider what we saw in 2006:

* A market driven by concerns over exteral imbalances in late winter/early spring, with carry trades performing horribly

* Stocks take a pummeling in the spring as liqudity is withdrawn on inflation concerns

* Stocks put in a stunning reversal in late June and rally strongly through the end of the year

In 2007, what have we seen?

* A market obsessed with carry and contemptuously dismissive of current acccount considerations in late winter and the spring

* Stocks rally strongly in the spring even as interest rates rise on rising growth prospects

The final leg of the Bizarro juxtaposition in 2007 would be a surprising reversal in equities some time around now. Will it happen? To be honest, Macro Man does not know. Could it happen ? Absolutely. And the catalyst could (finally) be that well-mined source of angst and worry, the US housing market.

Many (though not all) commentators have concluded that the worst is past for residential construction, with some even forecasting a positive growth contribution from the sector by the end of the year. Frankly, this seems absurd. Homebuilders have yet to even shed reported labour payrolls after a sharp rise in the previous few years; surely some rationalization of the workforce is a prerequisite for a bottom?

Consider also that the NAHB index continues to plumb new depths, registering a sixteen year low last night at 28. The weakness in the index suggests that res construction as a percentage of GDP could/should dip below 4% from the curent 4.5%. Today's housing starts data will provide a clue as to whether this may be taking place. And let's not forget our old friend called "structured credit." Unless Macro Man has been asleep at the wheel, he hasn't exactly noticed that the wave of long-overdue ratings downgrades has hit the wires recently. Somewhat ominously, the most toxic of the on-the-run ABX indices is now plumbing new lows (though admittedly the higher grade indices haven't moved.) Should this continue, or if the ratings agencies ever (gasp) downgrade already-underperforming CDOs, then perhaps the risk trade will finally come under pressure.

You may notice a similarity between the Markit ABX chart above and the last six months' worth of price action in Macro Man's buddy the XHB ETF. Again, somewhat ominously, the XHB is now perched on trendline support dating back to this time last year. The weekly trendline below is at 32.84, almost exactly where the XHB closed last night. A weekly close below the level would target a visit to last summer's sub-30 lows at the very least.

So there we go. Macro Man has found a defensive trade that he can buy into with gusto. He'll look to add to his short XHB exposure by spending $100k or so of option premium on puts. He'll look to buy 1200 August 31 puts this morning before the housing data; last night's closing price was $0.75.

On a completely separate note, how do you think Dr. Alan Bollard feels about being a laughingstock around the globe for getting run over by Japanese retail?

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A friend of mine works as a Portfolio Manager for a $2.2b CDO pool of subprime loans. I spoke to him today for an hour. Asked how he is doing, he says “nothing”. I ask what do you mean nothing, I hear all these stories about CDO’s and losses (Bear Stearns for example), he shrugs and says nothing will happen until the Rating agencies do something. Asked about losses, he says they are there but he doesn’t have to mark to market his portfolio until someone discovers it, or the Rating agencies force his hand. So his plan is to lie low and collect the management fees and pretend as if there are no losses. Asked about management fees, he laughs and says it’s a low 50 bips. On $2.2b, that’s a cool $10m yearly which he and his four colleagues have to split up at the end of the year. He says he has the best job in the world and says there is really no work to do every day. Just wait and hope that the rating agencies don’t downgrade his CDO pool and voila, at the end of the year, he and his partners can split the $10m spoils (minus the expenses for one Park Avenue office, and a secretary). I am amazed that no body (regulators, investors, the public) hasn’t beseeched the Rating agencies to review all the Subprime CDO’s by now given the headlines and the incredible losses hidden there.

but isn't the key difference between now and 2006 that inflation will not be an issue until September/October? Thus, risky assets could easily rally becoming overbought just in time for the superstitious believers in the "October of years that end in 7" effect.

That'll be the fourth time I've seen that item today. Anonymous, above, is the first to propose it as first hand information, however. The closest the others come is two degrees of remove from what is claimed to have been a comment seen by a poster at the "Prudent Bear", with no original hyperlink.

Hmm...yes, I see that the exact verbatim text was posted elsewhere a few days ago. Oh, the shame of cyber-sloppy seconds! Anonymous #1, I have no problem with anyone copying or linking to material they'd seen elsewhere; all I'd ask is that you attribute it as such.

That having been said, even if this particular story in its verbatim incarnation is a generalization (I believe "composite" is the Hollywood term), I think the general theme rings true. Just about everyone I talk to involved with credit is asking the same question: when are the ratings agencies going to pull their finger out and get around to downgrading the crap?

Anonymous # 2, you are right that year on year comps for inflation data will look pretty good til late summer. Of course, as I posted a few days ago, headline CPI in the US is already up 3% year-to-date, so it's not immediately obvious to me that inflation is THAT under control!

What I am suggesting here, however, is a credit event rather than an inflation event.